The economic tipping point: when could we see the RBA's moves start to impact inflation?

In 1964 The Beatles confessed that money can’t buy me love. In 2022, if prices keep rising, it won’t buy anyone much at all. Inflation in Australia is the highest it’s been in more than three decades, yet interest rates keep rising. So, when can we expect monetary policy to stifle these ballooning costs and return purchasing power to the people?

The Australian Bureau of Statistics (ABS) reported that the Consumer Price Index (CPI) rose 1.8 per cent in the September 2022 quarter, while the annual rate of inflation jumped 7.3 per cent - a level not seen since 1990.

Ongoing global supply chain delays and materials shortages, as well as Russia’s invasion of Ukraine, China’s covid-zero policy and other economic constraints are key drivers of inflation. However, concurrent interest rate hikes by the world’s central banks haven’t yet been able to put the brakes on unrelenting price advances. Why not?

Spending behaviour doesn’t turn on a dime

After more than a decade of cuts, the Reserve Bank of Australia (RBA) has already raised the official cash rate six times this year, from 0.10 per cent in April to 2.60 per cent in October. Four of the six movements were double-hikes of 50 basis points. Despite these rapid rate advancements, inflation continues to soar higher. 

The RBA’s explainer on The Transmission of Monetary Policy suggests that “there is a lag between changes to monetary policy and its effect on economic activity and inflation because households and businesses take time to adjust their behaviour”.

Interest rate hikes can take months to be fully priced into variable rate home loans. It’s at the behest of the banks to pass on increases in the cash rate to customers. A slew of borrowers who took out fixed-rate home loans during the covid pandemic are beginning to come off their ultra low fixed terms, generating masses of refinancing requests.

Some estimates suggest that it takes between one and two years for monetary policy to have its maximum effect. This is why we see banks and government agencies offer up long run inflation forecasts. However, any structural changes to the economy or varying budgetary conditions can spawn uncertainty in how prices might move.

How did we get here?

In the two decades leading up to the pandemic, prices were mostly trending downwards (see graph below). When lockdowns were enforced in 2020, consumer demand surged.

Source: Australian Bureau of Statistics

The government countered the pandemic’s recessionary conditions by implementing emergency stimulus packages, such as JobKeeper payments and HomeBuilder grants.

Independent economist Saul Eslake explained to Forbes that, “People were spending more time at home and decided to renovate. They didn’t want to catch public transport, so they bought cars. There was all this demand-shock and governments threw a lot of money at people, which meant that they could afford to buy these things.”

As spending shot up, cost and supply issues began mounting as lockdowns forced the closure of international factories and global shipping operations. Overwhelming domestic demand, coupled with rising energy prices, record low unemployment and upward pressure on wages has pushed inflation higher and higher.

But it's corporate profits, not labour costs, that have had the most significant impact, according to the Australia Institute’s recent discussion paper analysing the purported role wage growth has played in driving up inflation.

The Australia Institute inferred that while businesses and firms must set prices sufficient to cover their costs of production, many have exceeded this indicator, raising prices to maintain or increase their profits. The research firm suggests competition policy and other policies designed to control prices have a role to play in reducing inflation.

When will inflation peak? 

Although monetary policy decisions may take years to have a lasting impact, we may be able to observe the effects of the recent rate hikes on inflation as early as next year, according to the RBA.

“A further increase in inflation is expected over the months ahead, before inflation then declines back towards the 2-3 per cent range,” RBA governor Philip Lowe said in his latest statement on monetary policy.

“The Bank’s central forecast is for CPI inflation to be around 7¾ per cent over 2022, a little above 4 per cent over 2023 and around 3 per cent over 2024.”

Is the RBA better equipped to handle inflation than other central banks?

It's likely we'll see a seventh consecutive interest rate rise when the RBA meets next Tuesday, with a 25 basis point increase most likely. That would take the cash rate to 2.85 per cent, the highest since the April 2013 meeting.

Following a string of double rate hikes (50 basis points), the RBA Board’s decision to return to a single rate rise (25 basis points) at the October meeting was in stark contrast to overseas central banks that have been increasing interest rates by even larger increments.

“In part, this reflects our particular economic circumstances. But it is also relevant that the Board meets more frequently than most of our peer central banks,” RBA deputy governor Michele Bullock told attendees during a speech at the Australian Finance Industry Association (AFIA) annual conference earlier this month.

“This is a particular advantage in uncertain times, as it allows more frequent evaluation of the evidence and recalibration if necessary. It also means that if we increase interest rates at every meeting, we can potentially move much faster than overseas central banks.”

The Reserve Bank of Australia (RBA) Board meets on the first Tuesday of every month, except in January. That’s 11 times per year. Comparatively, the United States’ Federal Reserve’s Federal Open Market Committee (FOMC) meets eight times a year to hand down monetary policy decisions.

The European Central Bank’s (ECB) Governing Council meets every six weeks - eight times per year - to set the key interest rates for the euro area. The Bank of Canada (BoC) meets eight times a year to determine monetary policy and the Reserve Bank of New Zealand (RBNZ) reviews monetary policy just seven times a year.

What’s the outlook for everyday Aussies?

It’s likely we’ll see further interest rate rises this year. Many borrowers who applied for loans before rate hikes returned in May are likely to be paying interest rates close to or above the serviceability buffer their lender tested their application on. 

This means homeowners could be paying more in interest than they could reasonably afford. Additionally, property price declines may continue, further reducing equity shares for mortgage holders.

Many Australians are refinancing their home loans. If you’ve switched lenders but now realise you want to go back, you’ll likely need to begin the entire refinancing process all over again.

Treasurer Jim Chalmers delivered the 2022/23 federal budget this week, outlining the financial approach the government will take to secure Australia’s economic future. Despite fears of a looming global recession, the budget produced seven interesting and potentially positive revelations.

Homebuyers, investors and refinancers may want to look beyond interest rates and consider other features and benefits when comparing home loans.

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